Thirty Year Fixed Rate Mortgages Should be as Low as 2.60 Percent Says Fed

The Federal Reserve Bank of New York published a very interesting article on why 30 year fixed mortgage rates are hovering around 3.30 percent and are not as low as 2.60 percent, where they should be based on one measure. Since the Financial crisis of 2007 mortgage rates have made a series of record lows because of several factors including the Federal Reserve buying mortgage backed securities (MBS) to drive rates lower.

MBS are bundles of mortgage loans sold to investors, bundling mortgage loans and selling them to investors frees up capital so mortgage companies can make more loans.

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The Fed is buying MBS to provide more liquidity to the market to drive MBS prices lower which in turn will drive mortgage rates lower as well. Both mortgage rates and yields on MBS have moved lower since the Fed's policy was enacted but the declines in the latter have been more pronounced.

In fact, if the declines in the secondary market (MBS) were passed through to loan rates one-for-one, the average mortgage rate would now be around 2.60 percent. Rates in this week's Primary Mortgage Market Survey (PMMS) are averaging 3.34 percent, almost 75 basis points higher.

The chart to the right shows the rate spread between the primary mortgage market and secondary mortgage market. The spread difference has increased 70 basis points to 115 basis points today from around 45 basis points in 2007. This begs the question why mortgage rates today are not at 2.60 percent instead of where they are at 3.3o percent.

Before we get into why current mortgage rates haven't fallen as much in the primary market as they have in the secondary market, I'd like to first point out that there are some lenders quoting current mortgage rates only about 25 basis points higher than 2.60 percent. The lowest fixed 30 year mortgage rates we have seen on our rate table the past couple of months is at 2.875 percent. Granted, to get this low rate you have to pay points but nonetheless, the rate is available and only slightly above where rates should be according to the New York Fed.

There are several reasons why the spread between the two markets is increasing, including the fact that yields on MBS can be directly observed and are computed under a number of assumptions that according to Fuster and Lucca, "are particularly sensitive to misspecification in the current environment."

Another main factor is the spread doesn't take into account the guarantee fees on loans charged by Fannie Mae or Freddie Mac, which have increased from 20 to 25 basis points before 2008 to about 50 basis points today. If you just factor in the fees that are charged by the GSE's, the rate difference between the lowest rates available right now and the secondary market rates, the spread difference makes sense.